aicpa's sec conference grapples with building public trust

CCC 1044-8136/99/1003081-08© 1999 John Wiley & Sons, Inc.

Thomas R. Weirich and Robert W. Rouse

AICPA’s SEC Conference Grappleswith Building Public Trust

Thomas R. Weirich, Ph.D., CPA, isArthur Andersen Professor at CentralMichigan University. He has servedas academic fellow at the SEC, andfaculty in residence with ArthurAndersen’s Business Fraud andInvestigative Services practice.Robert W. Rouse, Ph.D., CPA, is aprofessor at the College ofCharleston. He served as anacademic fellow in the Office of theChief Accountant at the SEC. Heis a member of the SEC Regula-tions Committee of the AICPA.

SEC officials made a bid for greater cooperation from financial managers andindependent auditors—to build public trust in the financial markets. Conference-goers also got to listen to the SEC’s thinking on a variety of other issues. © 1999 JohnWiley & Sons, Inc.

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History repeats! The American Institute of Ceritified Public Accountants(AICPA’s) Twenty-Sixth Annual SEC Developments Conference was

held to another overflowing crowd on December 8 and 9, 1998 in Washington,D.C. The conference provides the opportunities to hear representatives of theSecurities and Exchange Commission (SEC), the Financial Accounting StandardsBoard (FASB), and other standards setters involved in the promulgation ofgenerally accepted accounting principles (GAAP) and generally accepted auditingstandards (GAAS), as well as representatives of the newly created IndependenceStandards Board.

Although there was no announced theme, the focus of many comments wasone of building a partnership for public trust in the capital markets. Specifictopics that highlighted the conference again were earnings management andauditor independence. This article will review the highlights of the speechesfrom the conference.

CHAIRMAN LEVITT’S COMMENTSArthur Levitt, chairman of the U.S. Securities & Exchange Commission,

was the first to focus on this partnership for the public trust. He began hisremarks by recognizing the perseverance of the third SEC chairman, JamesLandis, in his solicitation of the accounting profession’s help in enacting thefederal securities legislation in the early thirties. Landis commented to theaccounting profession, “We need you as you need us.” Over the years theaccounting profession and the Commission have supported one another increating the most efficient and effective capital markets in the world.

Chairman Levitt once again requested the support of the accountingprofession to work as a team with the Commission on three issues that are

82 The Journal of Corporate Accounting and Finance/Spring 1999


critical to the health of the capital markets and the integrity of the financialreporting system: (1) avoidance of the temptation to sacrifice sound financialreporting practices for the expectations of Wall Street; (2) maintaining of thehighest quality accounting and auditing standards in an increasingly global andtechnology driven marketplace; and (3) upholding of independence, objectivity,and professionalism within the accounting profession.

He then addressed the following topics: earnings management, honoringthe public trust, and the demand for strong accounting standards. With regardsto earnings management, the chairman stated that he is concerned that registrants’desires to meet Wall Street’s earnings expectations may be overridingcommonsense business practices. As a result, he reported a fear of erosion in thequality of financial reporting. The problem, he stated did not develop over-night. A cultural change in the financial community may be needed to changeregistrants’ objective of earnings management.

The chairman also announced a coordinated plan to address the issueof earnings management. Various committees and task forces have beenestablished to address these concerns. He complimented the leadership ofthe AICPA and was pleased with the creation of a task force of auditors,industry accountants, appraisers, and standard setters that will address theissue of “in-process research and development.” Also, he noted that theNew York Stock Exchange and the National Association of SecuritiesDealers have created a blue-ribbon committee to develop recommendationsto strengthen the role of audit committees.

Mr. Levitt further stated that the auditing profession needs to keep pacewith the rapidly changing environment in order to maintain the public trust inthe capital markets. Advancements in technology and globalization have changedthe ways that business is conducted. The chairman then questioned theeffectiveness of the audit process under the current audit risk model andconcluded his remarks by addressing the international efforts to reduce disparitiesin reporting and disclosure requirements. The newly proposed global accountingstandards must meet the fundamental test of providing transparency,comparability, and full disclosure that is currently demanded by SEC.

COMMENTS FROM THE OFFICE OF THE CHIEFACCOUNTANT

Lynn Turner, newly appointed chief accountant of the Commission,elaborated upon Chairman’s Levitt’s remarks concerning a partnership ofrepresentatives of financial management, business executives, public accountants,attorneys, and others to protect and enhance the transparency in financialreporting in order to protect the investor. He thanked those in government,members of financial management, and auditors who have diligently worked tomaintain this partnership of cooperation.

Mr. Turner then provided his thoughts of a vision for the accountingprofession for the 21st century, which focused on leadership and professionalism.He expressed the need for increasing the level of professionalism in publicaccounting and financial management. After citing such business articles as“Pick a Number, Any Number,” and “Accounting Abracadabra,” Mr. Turnerreported that the investing public expects high quality in financial reporting.There is a current need for leadership to take financial reporting and the

Mr. Levitt further statedthat the auditingprofession needs to keeppace with the rapidlychanging environment inorder to maintain thepublic trust in the capitalmarkets.

The Journal of Corporate Accounting and Finance/Spring 1999 83

AICPA’s SEC Conference Grapples with Building Public Trust

auditing profession into the 21st century. This leadership should demonstratethe willingness to present new ways to have more effective audits, to improve thefinancial reporting model, to meet the needs of globalization of the capitalmarkets, to protect the private standard-setting process, and to incorporate thechanges in information technology.

Mr. Turner’s remarks then addressed audit effectiveness. He questionedwhether the audit process has kept pace with the revolutionary changes ininformation technology within the business community. Another concern wasthat the current audit staff may not have an adequate understanding andknowledge of auditing procedures and business operations sufficient to conductan effective audit of a complex business. At the request of Mr. Turner, the PublicOversight Board has established a committee with the charge to investigate theeffectiveness of audits given the current audit risk model. A report from thiscommittee is expected later this year.

He concluded his remarks by expressing the importance of the professionto continue to demonstrate to the public its capability and desire to remain aneffective self-regulated organization. Additionally, he commented that theprofession needs to support the private standard-setting process and to contributeto the future evolution of both international accounting and auditing standards.

Jane Adams, deputy chief accountant of the Commission, also focused onChairman’s Levitts’s remarks when she addressed the earnings managementissues. As a result of the Commission’s concerns related to earnings management,the SEC staff will be shortly issuing three new Staff Accounting Bulletins(SABs). These bulletins will provide insight in interpreting and applyingexisting standards. The three forthcoming SABs will address the followingareas: restructuring charges and impairments of assets, revenue recognition,and materiality.

Restructuring Charges and Asset ImpairmentRecognition of restructuring charges has long been a concern of the

Commission for years. The Emerging Issues Task Force (EITF) issued twoconsensuses, EITF 94-3, Liability Recognition for Certain Employee TerminationBenefits and Other Costs to Exit an Activity (Including Certain Costs Incurred ina Restructuring), and EITF 95-3, Recognition of Liabilities in Connection with aPurchase Business Combination. However, Ms. Adams stated that these twoconsensuses have not resolved the reporting problems. She reported that theconsensuses were developed with the objective of identifying the circumstancesin which the actions of management create a liability that should be recorded onthe commitment date. The consensuses have focused specifically on criteria ofthe essential characteristics of a liability—that is, does management have littleor no discretion to avoid a future sacrifice?

In evaluating a number of restructuring accruals, Ms. Adams identified thefollowing observed deficiencies relating to the recognition of a liability:

• The exit plan lacked sufficient specificity of the actions to be taken.• The exit plan was significantly modified as it was being implemented,

which may suggest that the exit plan may not have existed.• The exit plan would not be completed in the near term, which provides

management with much discretion.

Recognition ofrestructuring charges haslong been a concern of theCommission for years.



• Costs could not be reasonably estimated, which is a requirement foraccruing a liability.

Ms. Adams also commented on the fact that the staff has objected to theaccrual of costs in certain circumstances in which the staff concluded that thecosts either did not represent the exiting of an activity or the costs benefitedfuture operations. An additional observation was that bad accounting was oftenaccompanied by inadequate disclosure. There are certain required disclosuresthat must be made in the year that the liability is recognized and in subsequentperiods when such costs are paid.

A second issue in the accounting for restructuring costs is the impact ofFASB No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of. The issue is which impairment model is applicablewhen the commitment date for an exit plan also requires an impairmentevaluation prior to the ability to remove the related assets from operations? Thestaff has concluded that the recognition of an impairment charge is not asubstitute for choosing an appropriate initial useful life and salvage valuefollowed by an adjustment.

Revenue RecognitionMs. Adams then addressed the proposed SAB dealing with revenue

recognition with particular emphasis on the effect of refundability in theearnings process and the role of probability in determining when revenueshould be recognized. She stated that existing guidance provided by FASBConcept Statement No. 5, Recognition and Measurement in Financial Statementsof Business Enterprises, is very broad. This statement reports that revenue isrecognized when it is realized or realizable and it is earned.

Areas where the staff has concerns have been the recognition of revenue in thehealth care industry and memberships at golf courses. Such registrants haverecorded initial membership or initiation fees as revenue. The staff concluded thatthe receipt of the fee was not a discrete earnings event, but rather the purchase ofongoing rights or services. Therefore, the registrant should recognize a liability, notrevenue, for this initiation or membership fee. In a related issue, the staff concludedthat the activation fee for cellular telephone service should not be recognized asrevenue because the collection of the fee is not a discrete earnings event.

MaterialityMs. Adams concluded her comments by addressing materiality. Although

there are various definitions of materiality, each definition incorporates thebasic concept adopted by the courts and the Commission. An item is consideredmaterial if there is a substantial likelihood that a reasonable investor wouldconsider it important in making a decision. Additionally, the issue of materialityinvolves an evaluation of both quantitative and qualitative characteristics.

The staff will consider other factors in addition to quantitative characteristicswhen evaluating materiality. Examples of qualitative factors include situationsin which a conscious decision was made not to follow GAAP, in which factorswere involved in an erroneous accounting transaction that leads to a change inthe trends of earnings, or in which the factors were a part of a plan to smoothearnings from period to period

Ms. Adams alsocommented on the factthat the staff has objectedto the accrual of costs incertain circumstances inwhich the staff concludedthat the costs either didnot represent the exitingof an activity or the costsbenefited futureoperations.



Professional Accounting Fellows’ CommentsContinuing the tradition at the conference, the professional accounting fellows

(PAFs) within the Office of the Chief Accountant summarized specific concernsthat the Office has confronted during the past year. The issues were very complex,fact-specific, and covered a variety of unique situations. Although selected topicsare reviewed, the full text of the speeches can be obtained from the SEC Web site.

Paul Kepple (PAF) addressed the following issues: nonmonetary exchangetransactions, a purchase business combination valuation issue, a pooling matter,and an issue that related to immediate expense recognition of prepaid costs. Asto the first issue, Mr. Kepple informed the audience that SEC staff had submitteda letter to the EITF that outlined the scope of a project that will attempt toaddress a number of nonmonetary exchange issues in order to develop acohesive model for nonmonetary exchange transactions.

Concerning the business combination valuation issue, the staff objected tothe following conclusions of a registrant. Target Co. provided satellite servicesand was owned 100 percent by a foreign government. In a privatizationagreement, NEWCO (the registrant) acquired 100 percent of Target. However,the registrant was required to provide the government free access to 7 percentof Target’s available capacity. As a result of this agreement, NEWCO providedno accounting for the reserve capacity obligation and recorded only 93 percentof the fair value of the satellites at acquisition of Target.

The staff disagreed with the treatment since NEWCO maintained all therisks and rewards to ownership of the satellites. It also had the right to sell anyof the reserve capacity not used by the government. The staff concluded thatsince NEWCO owned 100 percent of the satellites, it must record the full 100percent fair value of such satellites.

Mr. Kepple also discussed an issue of whether a contractual asset dispositionwould prevent the use of the pooling-of-interests method. The staff concludedthat the registrant should not be able to accomplish through a contractualprovision what it is not permitted to do in a pooling transaction.

The final issue commented on by Mr. Kepple was Internet loss arrangements.He reported that a trend is developing whereby companies are entering intoarrangements that initially appear to be loss contracts, but after close inspectionare not. For example, an Internet service provider attempted to recognize a one-time nonrecurring loss as a result of entering into an agreement with an Internetaccess company. The service company paid a fixed cash payment to the accesscompany and recorded a loss based on the expected unrecovered costs over theestimated incremental advertising revenues. The staff disagreed and concludedthat amounts paid to maintain and increase user traffic on the system should becapitalized and amortized over the period the access is received. This prepaymentis no different than other prepayments for future services.

Robert Uhl’s (PAF) comments centered on (1) the initial measurement ofinterests providing credit enhancement in a securitization, (2) allowance forloan losses, and (3) accounting for trade credits. The staff has raised a significantnumber of questions regarding financial institutions’ allowances for loan losses.He reported that the staff will challenge those allowances that appear too low orexcessive, or are inconsistent with the discloses in filings with the Commission.

Jeffery Jones (PAF) addressed issues relating to (1) certain modifications ofemployee stock awards, (2) impairment of nonproductive assets, (3) push

The final issue commentedon by Mr. Kepple wasInternet lossarrangements. Hereported that a trend isdeveloping wherebycompanies are enteringinto arrangements thatinitially appear to be losscontracts, but after closeinspection are not.



down accounting, and (4) software revenue recognition. Mr. Jones reportedthat there has been significant attention given to the Year 2000 (Y2K) SoftwareIssue. Current business practices demand that software be Y2K compliantbefore licensing or that the vendor provide some assurance. Should revenue berecognized when the customers’ rights are covered by “bug fixing” unspecifiedupgrade rights under support arrangements, or when a specified upgrade/enhancement is specified? In an Interpretative Release for Year 2000 issues thestaff has stated that “if a vendor licenses a product that is not Year 2000compliant and commits to deliver a Year 2000–compliant version, the revenuefrom the transaction should be allocated to the various elements—the softwareand the upgrade.”

Eric Casey (PAF) focused on (1) tainted treasury stock, (2) new basisrelating to leveraged recapitalization, and (3) the accrual of a loss by a lesseerelated to an operating lease. Paul Desroches’ (PAF) comments addressed (1)structured debt instrument with embedded written options, (2) trust-issuedpreferred securities, (3) held-to-maturity securities under FASB Statement No.115, and (4) hedging with intercompany derivative transactions. Donald Gannonconcluded the PAF presentations with a discussion of issues relating to (1) theEuro as a reporting currency, (2) business combinations, and (3) the recognitionof goodwill and negative goodwill under the International Accounting Standards.

COMMENTS FROM THE DIVISION OF ENFORCEMENTWalter Schuetze, chief accountant of the Enforcement Division, who

returned to the Commission to assume the position, reported that there wasnothing new under the sun on the accounting side within the Division. Therewere only so many ways that one can cook the books. As usual, his speech,entitled, “Enforcement Issues: Good News/Bad News, Brillo Pads, Miracle-Gro,and Roundup,” was very interesting—and addressed a myriad of issues.

The good news involved the discussion of statistical information related tothe accounting enforcement cases. In 1997 the Commission completedapproximately 100 accounting enforcement cases. Since there are some 16,000public companies filing with the Commission, an 0.6 percent enforcement caserate may initially indicate that most registrants are conforming to the SEC rules.However, Mr. Schuetze tempered the good news with the bad news when heconcluded that the statistics might not be correct.

He briefly highlighted a July 1998 Business Week article that reported on asurvey of chief financial officers (CFOs) and focused on one question, whichreported that 67 percent of the CFOs responding had been asked to “misrepresentresults.” Eighteen percent of those that were asked actually did misrepresentresults. Mr. Schuetze inferred these statistics to the population of the 16,000issuer/registrants. Applying the 67 percent statistic to the population, inapproximately 11,000 cases (16,000 x .67), CFOs would be requested by otherexecutives within the organization to “misrepresent results.” Approximately2000 cases (11,000 x .18) may exist where CFOs actually gave into the request—a very alarming statistic indeed!

Mr. Schuetze then reflected on another troublesome development henoticed from reading the newspapers. Some registrants are turning to “forensic”auditors from other firms rather than to their own auditors when questions ariseabout the registrant’s financial statements. As reported by Mr. Schuetze, these

Current business practicesdemand that software beY2K compliant beforelicensing or that thevendor provide someassurance.



forensic auditors bring in their Brillo pads and “scrub” the financial statements—resulting in restatements the size of an elephant! Therefore, the question is:Which firm did the real audit? He questioned the original auditing firm’sobjectivity and skepticism, which may be impaired or dulled by relationshipsbetween the auditors and their clients at picnics, golf outings, or other sportingevents. The issue of fraternization between the auditors and their clients is amajor concern of the Commission.

Mr. Schuetze concluded by addressing issues that the Enforcement Divisionworked on last year. The issues could be categorized as “pedestrian issues.” He citedseveral independence issues in which the auditor promoted the stock of a client andengagements in which audit and tax partners and staff owned client securities.

Premature revenue recognition and the use of reserves are of concern to theEnforcement Division. Mr. Schuetze cited cases involving the recognition ofrevenue when an undisclosed right of return exists, recognizing consignedgoods as sold, recording revenue on goods shipped to company warehouses,and recognizing revenue in advance of the customer’s acceptance of theproduct.

As to the issue of reserves, Mr. Schuetze reported that some registrants“bleed” into income without adequate disclosure of “reserves” that wereestablished in business combinations or restructurings. He stated that reserves,like tax liability cushions, deferred tax asset cushions, inventory reserves, baddebt reserves, merger reserves, and restructuring reserves, were like crab grass—they were everywhere! He believed that some companies kept Miracle-Gro inthe garage and periodically irrigated their crab grass general reserve accounts.Although the Division of Enforcement squirts Roundup on a registrant’sfinancial statements, the crabgrass keeps reemerging. Mr. Schuetze concludedthat these reserves are like a chocolate chip cookie jar into which managementcan not resist putting their hands when their earnings need a “sugar high.”

OTHER COMMENTSThe staff of the Division of Corporation Finance reported that earnings

management and restructuring charges will be major areas of emphasis in theirreview of filings with the Commission. The review of recent filings provided thefollowing examples of earnings management:

• Excessive accruals or manipulation of accruals for loan losses andrestructuring charges

• Excessive valuations of purchased in-process research and development• Improper write-downs of assets that continue to be used in operations• Unreasonable lives for depreciation and amortization• Improper recognition of future operating losses, or deferral of current

operating losses• Front-end recognition of revenue

Other issues of concern include business combinations, exchangetransactions, amortization of intangible assets, and textual disclosures inManagement Discussion & Analysis (MD&A). Other speakers at the conferencepresented issues relating to Internet issues and disclosures in cyberspace, newaudit and attest standards, and issues relating to international accounting.

The staff of the Division ofCorporation Financereported that earningsmanagement andrestructuring charges willbe major areas ofemphasis in their reviewof filings with theCommission.



SEC SEEKS GREATER COOPERATIONAs in previous SEC Developments Conferences, this year’s conference

provided the unique opportunity to learn of the current issues facing theprofession. However, at this conference, the Commission requested greatercooperation from financial managers and independent auditors to enhance thepublic trust in the financial markets. Some of these issues will mostly likely beaddressed at next year’s conference scheduled for December 7 and 8, 1999. ♦

aicpa's sec conference grapples with building public trust

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